Currency depreciation explained

Zimbabwe has been experiencing a renewed depreciation of the official exchange rate since the end of October 2021 in response to the central bank’s measures to improve the efficiency of the foreign currency interbank auction system. The official USD/ZWL rate depreciated by 19% in the last two months of 2021 to ZWL108/USD after depreciating by only 5% between January and November 2021.

This came after the disparity between official and parallel market rates had widened to about 100% in the second half of 2021.

While the focus of these movements has been centred around the macroeconomic impact by economists and captains of industry, this piece turns to the impact of these currency rate movements on company performance.

In order to understand the effect of currency movements on companies’ financial accounts, one needs to note that local businesses whose products or services are predominantly used in Zimbabwe changed their functional currency from USD to ZWL in 2019 after the official return of the ZWL. This means that business performance is now reported in ZWL, and official currency rates are effective in the case of business transactions that were facilitated by foreign currency.

As a result, this has introduced foreign currency risk to businesses. This is further compounded by the strong relationship between inflation and currency rates in Zimbabwe, that is, any local currency depreciation relative to the USD is often followed by inflation because ZWL prices in Zimbabwe remain pegged to USD values.

An easy way to understand the impact of foreign currency risk would be to classify assets and liabilities between monetary and non-monetary assets.

Monetary assets are those that are extensively vulnerable to inflation and, in Zimbabwe’s case, currency risk. Whenever there is currency depreciation and inflation, these assets typically experience an erosion in value.

A prime example of a monetary asset is cash in the bank. Non-monetary assets, on the other hand, retain value in the face of currency depreciation and inflation to a larger extent. A prime example is real estate.

The same also applies to liabilities, where ZWL-denominated payables are a good example of monetary liabilities and warrant service obligations are an example of non-monetary liabilities.

Having more non-monetary assets and monetary liabilities during prolonged periods of inflation and currency depreciation is the best-case scenario for any business because non-monetary assets preserve value while the real burden of monetary liabilities eases during such periods. This best-case scenario is also complemented by revenue streams that come with a healthy portion of receipts denominated in hard FX.

However, there are many businesses that were caught off-guard by the changes in the functional currency in 2019 and have been exposed to foreign currency risk ever since. In particular, businesses with foreign-denominated obligations, such as Econet and Ecocash Holdings, have been on the short-end of this stick and we proxy the magnitude of this risk by foreign exchange losses.

Foreign exchange losses result when the ZWL value of a business’ FX-denominated obligations increase because of a depreciation of the local currency. For example, if a company holds an obligation of US$1 at the beginning of the year when the ZWL/USD exchange rate is 1:1 and the local currency depreciates to ZWL$10 per US Dollar at the end of the year, a foreign exchange loss of ZWL$9 will be effected in the year-end income statement of that business because the obligation goes from ZWL$1 to ZWL$10 in the functional currency.

In the period between January and October 2021, businesses with foreign currency-denominated obligations reported a significant decline in net exchange losses because the official interbank rate moved marginally from 81.78 to 88.55.

Econet, for example, reported exchange losses of ZWL$7.0bn between March and August 2020 because of an impact of the depreciation of the official exchange rate of 78% on its FX-denominated debentures during that period.

In the period between March and August 2021, however, this loss subsided to ZWL$0.3bn because the official rate depreciated by just 2% during the six months.

Given that the group’s second half of its latest financial year has been marked by a 24% depreciation of the official interbank rate, it is likely that exchange losses will make a larger dent in the second half of Econet’s financial year compared to the first half.

On the other end are local companies that traditionally hold an extensive portfolio of non-monetary assets which retain value during periods of inflation and currency depreciation in Zimbabwe.

This includes, but not limited to, real estate businesses whose asset book largely comprises land and commercial properties.

First Mutual Properties, for example, reported fair value gains of ZWL$5,8bn in its investment properties portfolio in the first half of 2020 when the official interbank rate depreciated by 71%.

However, these fair value gains declined to ZWL$0,4bn in the first half of the 2021 year because of marginal currency depreciation over the period of 4%. We opine that currency depreciation of 21% in First Mutual Properties’ second half of its 2021 financial year is likely to result in a resurgence of fair value gains in its accounting records.

Whether or not this changes the investment thesis for Econet, First Mutual Properties, or any other listed entity exposed to movements in currency rates is a discussion that an investor needs to have with their investment advisor.